************************** TRUSTS AND MARITAL PROPERTY

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1 ************************** I. TRUSTS AND MARITAL PROPERTY October 30, 2015 Family Law Intensive Seminar North Carolina Bar Association David E. Holm Cheshire Parker Schneider & Bryan, PLLC P.O. Box 1029 Raleigh, NC John N. Hutson Howard, Stallings, From, Hutson, Atkins, Angell & Davis, P.A Trinity Road, Suite 210 Raleigh, NC Stephen A. Brown Young, Moore and Henderson, P.A Glenwood Avenue, Suite 200 Raleigh, NC **************************

2 TABLE OF CONTENTS I. INTRODUCTION II. ASSET PROTECTION IN TRUST AND ESTATE PLANNING A. TRUSTS AS ASSET PROTECTION DEVICES 1. Key Trust Provisions a. Governing Law b. Debtor s Relationship to Trust 2. Self-settled Trusts and Trusts Created for Third-Parties a. Self-settled Trusts (1) General Rule: No Protection for Settlor (2) Exception: Protective Trusts (3) NC Proposed Protective Trust Statute b. Trusts Created for Third-Parties (1) Debtor is Beneficiary (2) Debtor is Beneficiary and Trustee (3) Debtor is Holder of Power of Withdrawal (4) Debtor is Settlor: No Strings (5) Debtor is Settlor: Strings 3. Case Studies: a. Ward v. Fogel (NC) b. Nicks v. Nicks (NC) c. Dahl v Dahl (UT) 4. Tax Considerations 5. Altering Irrevocable Trusts a. Power Holders b. Trust Decanting c. Trust Modification or Termination (1) Settlor and Beneficiaries Consent (2) Consent of Beneficiaries with Court Approval that Action furthers Material Purpose of Trust (3) Consent of Beneficiaries with Court Approval if Reason Substantially Outweighs Material Purpose of Trust (4) Court Approval without Beneficiary Consent if Nonconsenting Beneficiary s Interest Adequately Protected and Action Otherwise Permitted (5) Modification or Termination for Unanticipated Circumstances (6) Modification for Effective Administration (7) Termination of Uneconomic Trust (8) Reformation to Correct Mistakes (9) Modification to Achieve Settlor s Tax Objectives d. Judicial Proceedings B. BUSINESS ENTITIES AS ASSET PROTECTION DEVICES 1. General Utility a. Lack of Control I-1

3 b. Lack of Marketability 2. Trusts as Owners of Business Entities III. CONSIDERATIONS FOR EFFECTIVE ASSET PROTECTION PLANNING A. EQUITABLE DISTRIBUTION AND INHERITANCE B. FRAUDULENT CONVEYANCES 1. Present and Future Creditors 2. Solvency 3. Federal vs. State Law 4. Statute of Limitations 5. Avoidance of Transfer C. FIDUCIARY DUTIES AND CONFIDENTIAL RELATIONSHIPS 1. Confidential Relationships 2. Limitations on Claims 3. Fiduciary Duties and Non-marital Relationships D. MARITAL RIGHTS UPON THE DEATH OF A SPOUSE IV. REACHING ASSETS IN TRUST IN THE MARITAL CONTEXT A. PROCEDURAL MATTERS B. CLAIMS CHECKLIST V. CONCLUSION I-2

4 TRUSTS AND MARITAL PROPERTY 1 I. INTRODUCTION Marital rights raise complex questions in trust and estate planning. These questions may arise unintentionally as when a spouse desires to transfer assets to a company, trust or family member for the purpose of reducing his or her wealth transfer tax exposure. In other cases, a spouse may intentionally transfer assets in an effort to reduce or eliminate his or her spouse s interest in those assets. The timing, purpose and methods of transfer as well as the assets used to accomplish the transfer are crucial in evaluating the rights of the non-transferring spouse. This manuscript primarily analyzes the effectiveness of trusts as asset protection devices against marital claims. Part II proceeds with a general discussion of asset protection in trust and estate planning, appellate court decisions on the enforceability of trust arrangements, tax considerations, and the ability to modify or alter the terms of an irrevocable trust. In Part III, the general legal considerations for effective asset protection planning using trusts are identified and discussed. Part IV addresses both the procedural and substantive aspects to challenging a trust arrangement in an equitable distribution proceeding. This manuscript is not intended to be, and is not, a comprehensive discussion of all asset protection tools available or issues to be considered when evaluating or engaging in asset protection planning. Practitioners should, however, glean a general understanding of the primary options available for a client interested in asset protection planning using trusts as well as the arguments for and against honoring those arrangements in the marital context. II. ASSET PROTECTION IN TRUST AND ESTATE PLANNING Clients may be motivated to engage in asset protection planning for a variety of reasons. Their profession or business may pose a potentially high degree of personal liability or they may perceive a risk of susceptibility to an aggressive plaintiff s bar. Some clients may simply have the goal of avoiding a specific creditor like a spouse. Asset protection planning generally encompasses planning for all these purposes. However, a client s options are substantially affected by the circumstances existing at the time planning is desired. Forward-looking clients enjoy a wider range of available tools to achieve their objectives while clients engaging in crisisplanning are faced with substantial challenges and limitations. In all cases, practitioners should carefully consider their own ethical and legal obligations prior to advising clients in this area. Trusts and business entities are two commonly employed asset protection tools often in conjunction with one another. Their appropriateness depends on a series of factors ranging from plan development and implementation costs to the degree of control desired over the assets as well as the present status of creditors. In the marital context, a spouse may have significant interests in the client s assets or the client may owe certain duties to the spouse when engaging in certain transactions. These interests and duties must be assessed prior to engaging in any 1 Special thanks to Matthew Lawless, Howard, Stallings, From, Hutson, Atkins, Angell & Davis, P.A., for his contributions to this manuscript. I-3

5 protection planning strategies. Part III outlines many of these considerations. This Part provides a general overview of trust and business entities as asset protection tools. A. TRUSTS AS ASSET PROTECTION DEVICES Trusts can be valuable asset protection tools in appropriate circumstances. However, a trust s usefulness in this context is highly dependent on a series of factors including: the timing of the trust s creation; the identity and status of the settlor, trustee and beneficiaries; the terms of the trust, including its governing law; and the type of creditor. As discussed below, with one narrow exception, revocable trusts never protect assets from claims by the settlor s creditors. Accordingly, this section focuses primarily on the ability of irrevocable trusts to serve as asset protection tools. 1. Key Trust Provisions A trust is commonly defined as a fiduciary relationship with respect to property, subjecting the person for whom the property is held to equitable duties to deal with the property for the benefit of another person, which arises as a result of a manifestation of an intention to create it. See, e.g., Sinclair v. Travis, 231 N.C. 345, 353, 57 S.E.2d 394, 400 (1950); Restatement (Third) of Trusts 2 (2003). The relationship results from the separation of equitable and legal title to identifiable property. Sinclair v. Travis, 57 S.E.2d at 400. The settlor of a trust relinquishes legal title to property conveyed to a trust. Legal title to trust property is generally vested in the trustee with equitable title vested in the beneficiaries. Accordingly, questions arise regarding a creditor s ability to reach assets transferred in trust when a creditor is pursuing a claim against a settlor or beneficiary of the trust. Certain key trust provisions are initially controlling in this regard. a. Governing Law The trust s governing law generally determines whether the trust was effectively created and the rights of creditors to reach the assets in the trust. Under North Carolina law, the meaning and effect of the terms of a trust are determined either by (i) the law of the jurisdiction designated in the terms of the trust unless the designation of that jurisdiction s law is contrary to a strong public policy of the jurisdiction having the most significant relationship to the matter at issue, or (ii) in the absence of a controlling designation in the terms of the trust, the law of the jurisdiction having the most significant relationship to the matter at issue. G.S. 36C-1-107(a). As a result, a trust created in North Carolina may be governed by the laws of another jurisdiction subject to certain important limitations. As discussed below, a court may not respect a settlor s choice of law when doing so would be contrary to a creditor s rights in the forum state. See, e.g., In re Huber, 493 B.R. 798 (W.D.Wash. 2013)(declining to apply settlor s choice of Alaska law where assets and beneficiary were located in Washington State and Washington State had strong public policy against creditor protection for self-settled trusts). However, it is possible that a settlor may choose a jurisdiction s law that is more favorable to creditors than the forum state s law. Such a designation would appear to be enforceable in North Carolina. I-4

6 b. Debtor s Relationship to Trust A creditor s ability to reach trust assets depends largely on the debtor s relationship to the trust. A debtor may have one or more relationships to the trust, including possible status as settlor, trustee, beneficiary, trust protector or holder of a power of appointment. In North Carolina, a creditor of a debtor who merely serves as trustee of a trust cannot reach the assets of the trust. G.S. 36C Other relationships, however, require more analysis particularly when the debtor maintains multiple relationships to the trust simultaneously. Practitioners should be careful to distinguish creditor claims based on the status of the debtor from claims against the trust directly. Applicable law may prevent trust assets from being used to satisfy the creditor s claims based solely on the status of the debtor. The trust, however, may incur liability on some other basis as in the case of a fraudulent transfer. Part II.A. of this manuscript generally discusses a creditor s ability to reach trust assets based on the status of the debtor. Part III discusses alternate theories in which a creditor may reach trust assets. 2. Self-settled Trusts and Trusts Created for Third-parties A debtor s relationship with a trust will generally cause the trust to be categorized as either a self-settled trust or a trust created for third parties. There is generally no protection in the former and greater protection in the later. However, the line between the categories is not always clear. Clever practitioners have developed a myriad of devices to provide settlors and beneficiaries substantial control over trust operations and distributions without causing the settlor or beneficiaries to expressly assume a non-protected status with respect to the trust. As a result, a trust that appears on its face to be created by a settlor for the benefit of a third party may be functionally akin to a self-settled trust. Likewise, a trust established by a third party for the benefit of a debtor may also be functionally akin to a self-settled trust depending on how the trust is funded. While voluminous tax cases have discussed the effect of a settlor or beneficiary s powers over trust property for tax purposes, courts in other contexts have struggled to address the effect of a debtor s powers on a creditor s ability to reach trust assets. a. Self-settled Trusts (1) General Rule: No Protection for Settlor A self-settled trust is a trust in which the settlor is both the creator and beneficiary (or partial beneficiary) of the trust. Accordingly, self-settled trusts may include both revocable and irrevocable trusts. Revocable trusts are self-settled trusts and the assets of such trusts are subject to the claims of the settlor s creditors. G.S. 36C-5-505(a)(1). This rule is true both during the lifetime of the settlor and upon the settlor s death. G.S. 36C-5-505(a)(3); Livesay v. Carolina First Bank, 192 N.C. App. 234, 665 S.E.2d 158 (2008); Rush University Medical Center v. Sessions, 980 N.E.2d 45, 55 (Il. 2012)(stating the general common law rule). A trust is considered revocable if the settlor can revoke the trust without the consent of a trustee or person holding an I-5

7 adverse interest in the trust. G.S. 36C-1-103(16). As a result, a trust is not considered revocable if a person other than the settlor has the right to revoke the trust. Illustration #1: Peter creates a trust naming his wife and children as beneficiaries and his friend, Thomas, as Trustee. The trust provides that Peter reserves the right at any time to amend and revoke the trust in whole or in part by an instrument delivered to the Trustee. Peter alone funds the trust with $50,000. The trust is a revocable trust and the trust s assets are subject to the claims of Peter s creditors. Illustration #2: Same facts as Illustration #1 except that instead of providing that Peter reserves the right at any time to amend and revoke the trust, Peter s wife is given the right to amend and revoke the trust. The trust is not a revocable trust. The settlor, Peter, does not have the right to amend or revoke the trust. For a discussion as to whether the trust assets are subject to the wife s creditors, see below. A trust is presumed revocable unless the settlor specifically provides that the trust is irrevocable. 2 G.S. 36C-6-602(a). Accordingly, a trust governed by North Carolina law must generally provide by its terms that the trust may not be revoked by the settlor in order to be irrevocable. By implication, an irrevocable trust is any trust that is not a revocable trust. Irrevocable trusts are not, by definition, asset protection devices. In the context of selfsettled trusts, the general rule is that a creditor or assignee of a settlor may reach the maximum amount that can be distributed to or for the settlor s benefit from an irrevocable trust. G.S. 36C (a)(2). 3 Accordingly, the identity of the settlor is paramount is not always clear. A settlor includes any person who creates a trust or contributes property to a trust. G.S. 36C-1-103(17). The act of contributing property to a trust suggests a transfer for no consideration, but the term contribution is not defined. If more than one person creates or contributes property to a trust, each person is a settlor of the portion of the trust property attributable to that person s contribution except to the extent another person has the power to revoke or withdraw that portion. Id. Illustration #3: Peter creates a trust for the benefit of his wife, Paula, but does not contribute any property to the trust. Paula contributes $50,000 to the trust. Peter and Paula are settlors of the trust. The trust property is subject to the claims of Paula s creditors. Illustration #4: Same facts as Illustration #3 except that Peter retains the right to withdraw the trust property at any time. Peter and Paula are settlors of the trust. The trust property is subject to the claims of Peter s creditors. 2 Other jurisdictions may employ a contrary presumption. A practitioner must be careful to evaluate the law governing the trust and determine its terms in accordance with that law. 3 In North Carolina, this rule is subject to one notable exception. It is not uncommon for an irrevocable trust to be a grantor trust within the meaning of IRC 671 resulting in the trust being disregarded for tax purposes and the assets of the trust, including any income, gain or loss, being attributed to the grantor. In such a case, a trustee s discretionary authority to pay amounts to tax authorities or to the grantor for reimbursement of taxes on trust income or principal is not considered an amount that can be distributed to the grantor or for the grantor s benefit. G.S. 36C (a)(2a). I-6

8 Illustration #5: Peter is the sole beneficiary of a testamentary trust established by his late father. Under the terms of the trust, Peter has the right to distribute property to himself for his health, education, support and maintenance in his discretion. Rather than create his own separate trust, Peter contributes $50,000 to the testamentary trust after his father s death. Peter is considered the settlor of the testamentary trust to the extent of his $50,000 contribution. The $50,000 contributed to the trust (together with any additions attributable to that contribution) is subject to the claims of Peter s creditors. Illustration #6: Peter s is the sole beneficiary of a testamentary trust established by his later father. Under the terms of the trust, Peter has a right to distribute property to himself for his health, education, support and maintenance his discretion. Peter personally sells valuable farmland to the testamentary trust in exchange for a promissory note. Peter s status as a settlor of the trust with respect to the contributed property is not clear, however, Peter has a strong argument that he neither created the trust nor contributed property to the trust as the transfer was presumably for adequate consideration. Importantly, a creditor s ability to reach a settlor s interest in the trust applies without regard as to whether the irrevocable trust contains provisions that would otherwise provide for creditor protection, including spendthrift provisions, discretionary trust interests, and protection trust provisions discussed below. G.S. 36C-5-505(a). Illustration #7: Peter creates an irrevocable trust, funds the trust with $50,000, and names himself as beneficiary and his friend, Thomas, as Trustee. The trust provides that the decision to make a distribution to Peter is within the sole discretion of Thomas. The trust also contains a spendthrift provision and states that Peter s interest in the trust will terminate immediately if any creditor attempts to reach Peter s interest in the trust. The trust property is subject to the claims of Peter s creditors. (2) Exception: Statutory Protective Trusts The traditional rule that assets held in self-settled trusts are subject to the claims of the settlor s creditors is not without exception. At least fifteen states have enacted legislation providing various levels of creditor protection for self-settled trusts. North Carolina considered legislation providing protection for self-settled trusts in the last legislative session. For the reasons discussed below, these so-called domestic asset protection trusts ( DAPTs ) are vulnerable in many circumstances. Offshore protective trusts may provide a remedy for some of these deficiencies but are accompanied by certain disadvantages, including cost and complexity that make them unappealing to many clients. A discussion of offshore protective trusts is beyond the scope of this manuscript, but such trusts may be a viable option in appropriate cases. Similarly, DAPTs may prove useful in certain circumstances. The following discusses the general features and limitations of DAPTs. (a) Jurisdictions I-7

9 Nevada, South Dakota, Ohio, Tennessee, Alaska, Wyoming, Delaware, Missouri, New Hampshire, Hawaii, Rhode Island, Utah, Mississippi, Virginia and Oklahoma have enacted statutes providing protection to varying degrees for self-settled trusts. Alaska Stat ; Nev. Rev. Stat ; Del. Code. Ann. tit. 12, 3570 (2009); S.D. Code Laws ; Utah Code Ann ; R.I. Gen. Laws ; Okla. Stat. tit. 31, 10; Mo. Stat. Ann ; Ohio Rev. Code ; Tenn. Code. Ann ; Wyo. Stat. Ann ; Miss. Code ; H.R.S. 554G; N.H. Rev. Stat. Ann. 564-D:1-18; VA Code :2. (b) Required and Permissive Provisions A settlor must comply with the applicable statutory requirements in order to gain protection under a DAPT. There is some commonality among jurisdictions with regard to certain basic structural requirements and greater variance with respect to the rights of the settlor in the trust. DAPTs must generally be irrevocable and must apply the law of the applicable jurisdiction. Most jurisdictions further require that the trust contain a spendthrift provision. DAPTs were largely adopted under the belief that they could attract assets or revenue to the adopting jurisdiction. Accordingly, most DAPTs require appointment of an in-state trustee or the presence of a portion of the trust assets in the state. The following chart sets forth the common requirements for a trust instrument to qualify as a DAPT: REQUIRED PROVISIONS BY JURISDICTION Trust must be irrevocable Trust Provision Jurisdiction AK, DE, HI, MO, NV, NH, RI, SD, TN, UT, VA, WY, OH, MS OK (may be revocable or irrevocable subject to certain limitations) Trust must expressly state jurisdiction s laws govern Trust must contain a spendthrift provision All or part of trust corpus must be located in jurisdiction One or more trustees must be located within jurisdiction HI, OK, RI, TN, VA, WY, OH, MS, AK, DE, NH, SD AK, DE, MO, NH, RI, SD, TN, UT, VI, WY, OH, MS DE, NV, NH, OK, RI, TN, UT, VA, WY, OH AK, DE, HI, NV, NH, OK, RI, SD, TN, UT, VA, WY, OH, MS MO (required if no part of administration occurs in jurisdiction) Trustee must be trust company located within jurisdiction Beneficiaries must be only qualified beneficiaries (spouse, ancestor, descendants, etc.) Trust must contain mandatory state income tax language OK, UT (although individual co-trustees may serve together with institutional trustee) OK (settlor cannot be beneficiary, although possesses right to revoke) OK I-8

10 Trust assets may not exceed set limit Trust must have at least one beneficiary other than the settlor Settlor must have personal liability insurance Affidavit of solvency required from settlor Jurisdictional trustee must perform certain administrative functions OK ($1,000,000 limit) MI, VA (during any period distributions may be made to settlor) WY, MS ($1,000,000 personal liability insurance required) (In MS, up to $1,500,000 can be reached in trust if no insurance) AK, TN, WY, OH, MS AK, DE, HI, NV, NH, OK, RI, SD, TN, UT, VA, WY, OH In addition to the required provisions reviewed above, many statutes expressly state the interests that the settlor may retain in the trust. Commonly, these interests include the right to discretionary distributions, the right to income or a percentage of trust assets annually, and the right to remove and replace the trustee or trust advisors. The following is a general summary of a settlor s right to retain interests in a DAPT: PERMISSIVE PROVISIONS BY JURISDICTION Trust Provision Jurisdiction Right to income Right to at least 5% of trust assets annually Interest in GRAT, GRUT, QPRT and IRA Right to reimbursement of taxes Trust assets may be used to pay estate debts upon settlor s death Right to discretionary distributions Right to veto distributions General testamentary power of appointment Non-general testamentary power of appointment Retain right to remove and replace trustee Right to remove and replace trust advisor Out of state trust may move to jurisdiction and receive coverage as DAPT DE, HI, NV, NH, RI, SD, TN, WY, OH AK, DE, HI, NV, NH, RI, SD, TN, VA, WY, OH, MS AK, DE, NV, NH, RI, SD (QPRT), TN (CRT and QPRT), UT (CRT), VA (CRT, QPRT, GRAT), WY, OH (CRT), MS (CRT) AK, DE, HI, NV, NH, RI, TN, VA DE, NV, NH, TN, VA, MS AK, DE, HI, MO, NV, NH, RI, SD, TN, UT, VA, WY, OH, MS AK, DE, HI, NV, NH, RI, SD, TN, UT, WY, OH, MS HI (testamentary power for debts, administrative expenses, taxes), NV AK, DE, HI, NV, NH, RI, TN, UT, VA, WY (general or limited power of appointment), OH AK, DE, HI, NV, NH, SD, TN, UT, VA, WY, OH, MS AK, DE, HI, NV, NH, SD, TN, UT, VA, WY, OH, MS AK, DE, HI, NV, NH, SD, TN, UT, VA, WY I-9

11 While the above summaries are obviously a simplification of the complex jurisdictional options, they serve to demonstrate that potentially significant distinctions exist based on the retained powers of the settlor, the identity of the trustee, and the location of the trust property. (c) Creditor Protection Not all creditor claims are barred simply because the DAPT was properly implemented. Each jurisdiction excludes various claims from protection. Common exclusions include claims for alimony or property division if the spouse was married to the transferor on or before the date of the transfer. Claims for child support are generally also excluded. A minority of jurisdictions exclude claims for injury to person or property arising before the transfer. In addition, each jurisdiction employs statutes of limitations permitting a creditor a period of time to void a transfer to the trust. The limitation periods range from eighteen months to five years after the transfer is made to the trust. Accordingly, practitioners should use caution when selecting a jurisdiction to ensure that the primary claims of concern are barred. The following chart outlines the common exceptions from DAPTs: CLAIMS EXCLUDED FROM PROTECTION Type of Claim Eighteen months existing creditor statute of limitation Two year existing creditor statute of limitation Jurisdiction OH if longer, six months after transfer was or could reasonably have been discovered HI, NV, MS, SD NV, MS, SD if longer, six months after transfer was or could reasonably have been discovered Four year existing creditor statute of limitations AK, DE, MO, NH, OK, RI, TN, UT, WY NH, OK, RI, TN, UT, WY - if longer, one year after transfer was or could reasonably have been discovered Five year existing creditor statute of limitations Eighteen month future creditor statute of limitation after transfer Two year future creditor statute of limitation after transfer Four year future creditor statute of limitations after transfer Child support Alimony VA or, if longer, five years after transfer should have been discovered OK NV, MS, SD AK, DE, MO, NH, OK, RI, TN, UT, WY AK, DE, MO, OK, UT, WY if longer, one year after transfer was or could reasonably have been discovered AK, DE, HI, MO, NH, OK, RI, TN, VA, WY, OH, MS DE, HI, MO, VA, WY, NH, RH, TN, OH, MS I-10

12 Property division upon divorce HI, VA, WY AK - if assets transferred to trust 30 days prior to marriage) DE, NH, RI, TN, OH, MS - if spouse was married to settlor before or on date of transfer Tort claims for death or bodily injury DE, HI, NH, RI, MS - if arises from death, personal injury or property damage occurring before the transfer) UT under certain conditions Elective share and other marital rights upon death MO, OK, RH, SD, UT, VA, WY (d) Public Policy Limitations The advent of the domestic asset protection trust is counter to the traditional rule against self-settled trusts. In a nation of many jurisdictions, questions remain as to whether and to what extent the courts of federal or state jurisdictions that retain the traditional rule will protect beneficiaries of domestic asset protection trusts established and governed by the law of another jurisdiction. Courts could use their conflict of law rules to avoid the application of another jurisdiction s debtor-friendly laws. Section 270 of the Second Restatement of Conflict of Laws provides in relevant part as follows: An inter vivos trust of interests in movables is valid if valid... under the local law of the state designated by the settlor to govern the validity of the trust, provided that this state has a substantial relation to the trust and that the application of its law does not violate a strong public policy of the state with which, as to the matter at issue, the trust has its most significant relationship under the principles stated in Thus, 270 permits a court to consider the public policy of the jurisdiction with which a trust has its most significant relationship (which might or might not be the law designated by the trust instrument) in assessing the validity of a trust. However, the more important inquiry concerns the extent, if any, to which creditors can reach the assets of such a trust. Section 273 of the Second Restatement of Conflict of Laws is the starting point for this analysis. It provides in pertinent part as follows: Whether the interest of a beneficiary of a trust of movables is assignable by him and can be reached by his creditors is determined... in the case of an inter vivos trust, by the local law of the state... in which the settlor has manifested an intention that the trust is to be administered.... Unlike 270, 273 and its comments do not contemplate that a different rule might apply if the law of the trust's situs violates a strong public policy of another state. I-11

13 Even so, if some place other than the asset protection trust state is the forum, then the trust state's relation to the trust is arguably diminished, and a local judge may conclude that his or her state has a greater relation to the trust, and may choose to apply that state s policy. FTC v. Affordable Media, LLC, 179 F3d 1228, 1231 (9th Cir. 1999) (affirming district court's rejection of argument that Cook Islands trust law divested ownership interest, noting that "a district court judge and his common sense" are not "easily parted"); See In re Smith, 415 B.R. 222, (Bankr. N.D. Tex. 2009); Dexia Credit Local v. Rogan, 624 F. Supp. 2d 970, (Bankr. N.D. Ill. 2009); In re Lawrence, 227 B.R. 907, 917 (Bankr. S.D. Fla. 1998); In re Brooks, 217 B.R. 98, (Bankr. D. Conn. 1998); In re Portnoy, 201 B.R. 685, 698 (Bankr. S.D.N.Y. 1996) (refusing to permit Jersey Island law to defeat creditor s claim to assets held in a Jersey Island trust). Courts appear more willing to use the public policy exception imbedded in the conflict of law jurisprudence to prevent debtors from benefitting from out of state asset protection trusts when the debtor has engaged in attempts to evade existing or known potential creditors and not mere innocent estate planning. In the recent case of Waldron v. Huber (In re Huber), 493 B.R. 798 (U.S. 2013), a federal district court struck down a domestic asset protection trust created in a state other than the grantor s residence. The debtor was a citizen of Washington and placed nearly all of his assets into an Alaska domestic asset protection trust prior to the failure of his real estate business. The debtor then filed for chapter 11 bankruptcy protection. The bankruptcy judge granted summary judgment to the bankruptcy trustee, finding that the trust did not protect its assets from the claims of Donald s creditors and should be set aside on three separate bases, including applying Washington state law to the trust and not Alaska state law. The court held that the trust was not protected from the claims of the settlor s creditors by the provisions of Alaska law that expressly recognize the validity of self-settled asset protection trusts, but instead were invalid under the provisions of Washington law that reject self-settled spendthrift trusts. Compare Alas. Stat with Rev. Code Wash The court stated that the conflict between the laws of the two states must be settled under federal choice of law rules, rather than state choice of law rules, citing Lindsay v. Beneficial Reinsurance Co. (In re Lindsay), 59 F.3d 942, 948 (9th Cir. 1995). The court followed the choice of law rules set forth in the Restatement (Second) of Conflict of Laws, which states that a provision in the instrument governing an inter vivos trust of personal property that declares that the validity of the trust will be controlled by the law of a specific state will be followed only if (a) the state declared in the instrument as controlling has a substantial relation to the trust, and (b) the application of its local law does not violate a strong public policy of the state with which as to the matter at issue the trust has its most significant relationship. Restatement (Second) of Conflict of Laws 270 (1971); Liberty Tool & Mfg. v. Vortex Fishing Sys., Inc. (In re Vortex Fishing Sys., Inc.), 277 F.3d 1057, 1069 (9th Cir. 2002). Under the court s analysis, Alaska law would apply only if Alaska had a substantial relation to the trust. When this trust was created, neither the debtor nor the beneficiaries were domiciled in Alaska and the trust assets were not located in Alaska. The trust s only connection with Alaska was the location of the trustee and the administration of the trust in Alaska. On the other hand, when the trust was created, the debtor and the trust beneficiaries all resided in Washington, the trust assets were transferred from Washington, debtor s creditors were located I-12

14 in Washington, and the drafting attorney was located in Washington. When the trust was created, therefore, Alaska had only a minimal relation to the trust, but Washington had a substantial relation to the trust. Washington had a strong public policy against self-settled asset protection trusts; its statutes declare them void against both existing and future creditors. Rev. Code Wash ; Carroll v. Carroll, 18 Wash. 2d 171, 175, 138 P.2d 653 (1943); Rigby v. Mastro (In re Mastro), 465 BR 576, 611 (Bankr. W.D. Wash. 2011). Therefore, as the trust was a self-settled trust, Donald s transfers of assets into the trust were void, and the trustee was entitled to summary judgment voiding the transfers. The court held that the transfers to the trust were fraudulent under the Bankruptcy Code. Section 548(e)(1) of the Bankruptcy Code states that the trustee in bankruptcy may avoid any transfer to a self-settled trust or similar device made by the debtor on or within 10 years before the bankruptcy petition if the debtor is a beneficiary of such trust or device and the debtor made the transfer with actual intent to hinder, delay, or defraud any entity to which the debtor was or became indebted, on or after the date that such transfer was made. 11 U.S.C. 548(e). The court found that the parties conceded all of the elements required by Section 548(e)(1), except for the actual intent to hinder, delay, or defraud. The Bankruptcy Code also gives the bankruptcy trustee authority to bring suit to avoid fraudulent transfers under state law, and the court applied the Washington Uniform Fraudulent Transfer Act (UFTA) and not the more debtor friendly Alaska fraudulent transfer law. The court had already determined that the debtor was threatened with litigation when the transfers occurred; the transfers included substantially all the debtor s assets; and the debtor retained control of the transferred property. The court held that the evidence also established that: (a) as a self-settled trust, the transfer from the debtor to the trust was to an insider; (b) the debtor conceded that he did not receive consideration for transferring his assets to the trust; (c) by transferring the property into the trust, the debtor was attempting to remove the assets from the creditors reach; and (d) the debtor was desperate to protect and shield his assets. The court held that the trustee was entitled to summary judgment as a matter of law on its UFTA claim based on actual fraudulent intent. Other reported cases have addressed domestic self-settled asset protection trusts in the context of debtors that attempt to use their trusts to avoid known or reasonably known creditors, and the courts do not favor the debtors in these situations. United States v. Evseroff, U.S. Tax Cas. (CCH) 50,222 (E.D. N.Y. 2006), rev d and rem d, U.S. Tax Cas. (CCH) 50,240 (2d Cir. 2008), on remand, U.S. Tax Cas. (CCH) 50,328 (E.D. N.Y. 2012), aff d, 528 Fed. Appx. 75 (2d Cir. 2013) (applying New York fraudulent conveyance law to permit federal government to collect a tax debt from trust after proving actual fraud by debtor); Kilker v. Stillman, 2012 WL (Cal. Ct. App.) (express effort to shield assets from liability to reasonably foreseeable future judgment creditors constituted a fraudulent conveyance; alter ego concept also applied to defeat the trust); Rush University Medical Center v. Sessions, 980 N.E.2d 45 (Ill. 2012) (designation of Cook Islands governing law ignored when trust real estate assets located in Illinois were sufficient to satisfy a charitable pledge the settlor had failed to honor before dying); Watterson v. Burnard, 986 N.E.2d 604 (Ohio Ct. App. 2013), appeal not accepted, 135 Ohio St. 3d 1449 (2013) (the fact that the settlor died before a judgment was rendered did not alter the plaintiff s right to secure payment from the settlor s inter vivos trust). I-13

15 In the case of off-shore asset protection trusts, the courts universally apply United States Law, and are willing to hold beneficiaries of self-settled asset protection trusts in civil contempt and jail the beneficiaries until the assets are made available to the court s jurisdiction. FTC v. Affordable Media, LLC, 179 F.3d 1228 (9th Cir. 1999), and In re Lawrence, 279 F.3d 1294 (11th Cir. 2002); See also Securities and Exchange Commission v. Solow, 682 F. Supp. 2d 1312 (S.D. Fla. 2010), In re Coker, 251 B.R. 902 (Bankr. M.D. Fla. 2000), and Securities and Exchange Comm n v. Bilzerian, 112 F. Supp. 2d 12 (D. D.C. 2000) (all finding trust settlors in contempt for failure to comply with court orders to repatriate assets in offshore asset protection trusts). To date, courts have only applied this extreme sanction in cases involving offshore asset protection trusts. Self-settled asset protection trusts are a relatively new phenomena in American law, and to date, there are no reported cases of a non-asset protection jurisdiction applying the law of an asset protection jurisdiction to enforce an asset protection trust. (3) NC Proposed Protective Trust Statute North Carolina has not adopted a self-settled trust statute to date, but has considered selfsettled trust legislation. Senate Bill 466 (the SB 466 ), introduced during the legislative session, would have provided protection for certain transfers to qualified self-settled trusts from creditors other than claims for child support, alimony, post-separation support, or other spousal support or maintenance, a division or distribution of property or debts incident to marriage, certain damages for death, bodily injury or property damage, or claims by a surviving spouse for an elective share. Given the express non-application of the statute to marital rights, SB 466 would appear to have no express effect on the ability of a spouse to reach assets transferred to a qualified self-settled trust for purposes of alimony, spousal support, child support or equitable distribution. However, as the scope and effect of the SB 466 was hotly debated between certain segments of the legal bar, the proposed legislation or a similar version may well be proposed in the future. Accordingly, the general scope of the bill is discussed below with particularly emphasis on its effect, or lack thereof, on the marital rights of a spouse upon the dissolution of a marriage. SB 466 would have added a new Article 5A to the North Carolina Uniform Trust Code. The legislation generally tracts similar asset protection statutes from other jurisdictions. Proposed 36C-5A-1 provides that a settlor may transfer assets to a qualified self-settled trust and retain in that trust a qualified interest. In such cases, a creditor or assignee of the creditor would have only those rights with respect to a transfer to a qualified self-settled trust as provided in Article 5A. A creditor is expressly prohibited from reaching the settlor s qualified interest or a distribution from a qualified trust before the distribution is received by the settlor and the creditor may not compel a distribution from the trust even if the Trustee has abused the Trustee s discretion. A qualified self-settled trust is a trust for which all the following apply: (1) the trust is irrevocable; (2) the trust is created during the settlor s lifetime; (3) the settlor has a qualified interest; (4) there is at all times during the existence of the settlor s qualified interest at least one I-14

16 beneficiary other than the settlor to whom income or principal may be distributed; (5) the trust has at all times at least one qualified trustee; and (6) the trust instrument expressly incorporates the law of North Carolina to govern the meaning and effect of the trust. Proposed G.S. 36C-5A- 1. As one of the requirements is that a trust be irrevocable, the proposed statute makes clear that a trust instrument shall not be deemed revocable on account of the inclusion of any one or more of 14 enumerated rights, powers or interests of the settlor: The settlor s power to consent to a distribution from the trust. The settlor s power to consent to a trustee s investment decisions. A power of appointment exercisable by the settlor by will or other written instrument effective only upon the settlor s death, other than a power to appoint to the settlor s estate or the creditors of the settlor s estate. The settlor s qualified interest in the trust. A qualified trust interest is the settlor s right to receive discretionary distributions of trust income, principal or both in the discretion of a qualified trustee. Proposed G.S. 36C-5A-3. The settlor s right to receive income or principal pursuant to an ascertainable standard. The settlor s potential or actual receipt of income or principal from a charitable remainder unitrust or charitable remainder annuity trust (each within the meaning of section 664(d) of the Internal Revenue Code) and the settlor s power at any time, and from time to time, to release, in writing delivered to the qualified trustee, all or any part of the settlor s retained interest in that trust. The settlor s receipt each year of a percentage, not to exceed five percent (5%), specified in the trust instrument of the initial value of the trust assets or their value determined from time to time pursuant to the trust instrument. The settlor s power to remove a trustee. The settlor s power to appoint a trustee. The settlor s power to appoint a power holder. The settlor s potential or actual use of real property held under a personal residence trust, within the meaning of section 2702(c) of the Internal Revenue Code. The settlor s potential or actual receipt of use of a qualified annuity interest, within the meaning of section 2702 of the Internal Revenue Code. I-15

17 The ability of a qualified trustee, whether pursuant to discretion or direction, to pay, after the settlor s death, all or any part of the settlor s debts outstanding at the time of the settlor s death, the expenses of administering the settlor s estate, or any estate inheritance tax imposed on or with respect to a settlor s estate. A settlor s potential or actual receipt of income or principal to pay, in whole or in part, income taxes due on trust income, or the direct payment of those taxes to the applicable tax authorities, pursuant to a provision in the trust instrument that expressly provides for the direct payment of those taxes or the reimbursement of the settlor for those tax payments. Prop. G.S. 36C-5A-2(b). A transfer to a qualified self-settled trust retaining a qualified interest receives the protection of the statute even if the settlor retains any and all of the above powers and the settlor or the settlor s spouse retains certain rights as a power holder. Prop. G.S. 36C-5A-10(a). Importantly, however, a settlor may have only such rights and powers as are conferred by the trust and permitted under proposed Article 5A. A settlor can have no rights or authority with respect to trust property or income of the trust other than the rights set forth above and the right as a power holder to consent to a trustee s investment decisions, the right to consent to distributions from the trust, and the right to appoint a successor trustee. A creditor seeking to reach a qualified interest could do so only for avoidance of a transfer to the trust pursuant to the North Carolina Uniform Fraudulent Transfer Act, Article 3A of Chapter 29 of the General Statutes with certain exceptions. Prop. G.S. 36C-5A-7(a). A creditor whose claim arose after a transfer to a qualified self-settled trust may not bring a claim unless the transfer was made with the actual intent to hinder, delay, or defraud the creditor. However, the one-year limitation period found in G.S (1) does not apply to a creditor whose claim arose after the transfer to a qualified self-settled trust was made. A transfer is not deemed to have been made with intent to delay, hinder or defraud creditors merely because that transfer was made without receiving reasonable equivalent value in exchange. Prop. G.S. 36C- 5A-7(b). If a creditor were successful in avoiding a transfer, the interest is only avoided to the extent necessary to satisfy the settlor s debt to the creditor together with any costs and attorneys fees that the court may allow. Prop. G.S. 36C-5A-8(a). Unless the trustee or applicable beneficiary has acted in bad faith, the trustee has the right to collect the costs of defending the creditor s claim, including attorney s fees, and to honor any preexisting rights, claims, and interest of the trustee and the beneficiary has the right to retain distributions made upon the exercise of a trust power vested in the trustee or a power holder. Prop. 36C-5A-8(b). A creditor would generally not have any claims against the trustee, a power holder, or the attorneys that helped advise, create or fund the self-settled trust. Prop. 36C-5A-11. As stated above, the proposed legislation expressly exempts claims for child support, alimony, post-separation support, or other spouse support or maintenance, claims for division or distribution of property or debt incident to divorce, marriage or separation, and claims by a I-16

18 surviving spouse for an elective share. This significant carve-out means that a qualified selfsettled trust under the proposed legislation could not be used to shield claims arising from a spouse s marital rights. It would also lead some to argue it implies that the public policy of North Carolina prohibits self-settled trust protections for marital claims. Others argue that, if enacted, the legislation would permit North Carolina residents to establish DAPTs in other states that allow less or no family law claims and argue that North Carolina courts should enforce them because North Carolina no longer has a broad public policy against self-settled trusts. e. Trusts Created for Third-parties Trusts in which the settlor does not retain a beneficial interest are by definition trusts created for third-parties. Trust assets generally have protection from creditors when non-settlors exclusively enjoy the beneficial interests. However, a settlor may wish to retain certain powers over the trust property or may even want to serve as trustee. In addition, a beneficiary may be given withdrawal rights over trust property or may serve as Trustee. Questions arise over the degree of separation between the debtor and the trust needed to maintain creditor protection. In certain circumstances, courts have struggled to determine where to draw the line. This section examines a creditor s ability to reach assets in a trust created for the benefit of someone other than the settlor. (1) Debtor is Beneficiary Trusts are generally effective tools for shielding trust assets from the claims of a beneficiary s creditors provided the trust contains certain protective terms. Historically, North Carolina courts have generally found trust assets to be beyond the reach of creditors when the beneficiary s right to distributions is either entirely discretionary or subject to a prohibition against alienation, commonly known as a spendthrift clause. See Chinnis v. Cobb, 210 N.C. 104, 185 S.E. 638 (1936); Lineback by Hutchens v. Stout, 79 N.C. App. 292, 339 S.E.2d 103 (1986). Today, a creditor is generally statutorily prohibited from reaching a beneficiary s interest in such a trust. The North Carolina Uniform Trust Code broadly provides that the court may authorize a creditor to reach a beneficiary s interest for present or future distributions. G.S. 36C-5-501(a). However, this general rule does not apply if the trust (i) contains a spendthrift provision, (ii) the beneficiary s interest is discretionary, or (iii) the beneficiary s interest terminates or changes to a discretionary interest if a creditor attempts to attach to the interest. G.S. 36C-5-501(b). These restrictive provisions operate independently and serve distinct purposes. Accordingly, trusts may contain one or more of these restrictions depending on the purpose of the trust. A spendthrift provision is a provision term of a trust that restrains both voluntary and involuntary transfers of a beneficiary s interest. G.S. 36C-1-103(18). As a result, a beneficiary may not assign his or her interest in the trust to any other person or entity. Any attempt to do so is void. G.S. 36C-5-502(c). North Carolina law facilitates the incorporation of such provisions into a trust. It is sufficient to state that the interest of a beneficiary is subject to a spendthrift trust or other words of similar import to gain the protection of the statute. G.S. 36C-5-502(b). Significantly, a spendthrift provision does not mean that a beneficiary is prohibited from I-17

19 receiving mandatory distributions under the terms of a trust. A trust may require a beneficiary to receive distributions annually or upon the occurrence of some other milestone. A spendthrift provision prohibits a beneficiary from alienating that interest. It does not, however, relieve the trustee from making a required distribution. A creditor may reach the funds after distribution to the beneficiary. If a trustee fails to make a mandatory distribution within a reasonable time after the designated distribution date, a creditor may reach the trust assets to the extent of the distribution regardless of the spendthrift provision. G.S. 36C-5-506(b). Accordingly, a spendthrift provision has limited usefulness for a beneficiary with a continuing right to distributions. To fill the gap left by a spendthrift provision, a trust may also provide a beneficiary s interest is a protective trust interest. G.S. 36C-5-501(b). A protective trust interest is an interest that either terminates or becomes discretionary if the beneficiary attempts to alienate the interest, becomes insolvent or files bankruptcy, or a creditor attempts to reach the interest. G.S. 36C Protective trust interests provide flexibility for settlors desiring to give beneficiaries a right to distributions with a degree of asset protection. In many cases, a settlor may not want a beneficiary to be entitled to mandatory distributions. The beneficiary may have present creditors or have a general propensity for frivolous spending. Alternatively, the settlor may simply want to preserve assets for future generations or protect assets from wealth transfer taxes. A settlor may therefore elect to provide a beneficiary with a discretionary trust interest. A discretionary trust interest is simply an interest in a trust that is subject to the trustee s discretion. G.S. 36C-5-504(a)(2). 4 In a discretionary trust, the trustee determines when and to what extent to make distributions to a beneficiary. In some cases, the trustee s discretion is absolute, subject only to the general prohibition against acting in bad faith, dishonestly, with an improper motive, or failing to act prudently in accordance with the purposes of the trust and the interests of the beneficiaries. G.S. 36C-8-814(a). In other cases, the trustee is required to make distributions in accordance with a standard of distribution, commonly for the beneficiary s health, education, maintenance and support. In either case, the trust is generally considered a fully discretionary trust for asset protection under North Carolina law and receives protection from the beneficiaries creditors by statute. G.S. 36C-5-504(a). 5 Not every jurisdiction observes the same protection for trusts subject to a standard of distribution. See, e.g., N.Y. EPTL Practitioners should, therefore, carefully 4 A discretionary trust interest includes, by statutory application, a prohibition against the transfer of the interest by a beneficiary, whether voluntarily or involuntarily. G.S. 36C-5-504(b). 5 The authors note that G.S. 36C-5-504(a)(2)b. provides that a discretionary trust includes a trust in which the trustee, in the trustee s discretion, determines distributions are appropriate for support, education, or maintenance of the beneficiary. The statute does not include health within the applicable standard of distribution. Therefore, some question exists as to the purpose and effect of this omission. G.S. 36C-5-504(f) provides that a creditor may not reach the interest of a beneficiary who also serves as a trustee if the trustee s discretion to make distributions for the trustee s own benefit is limited by an ascertainable standard. G.S. 36C-1-103(2) defines an ascertainable standard to mean a standard relating to an individual s health, education, support, or maintenance with the meaning of the Internal Revenue Code. It makes little sense, in the authors view, to conclude a discretionary trust interest generally does not include a trust that contains a distributional standard including health but does include that standard when the beneficiary serves as trustee. Moreover, G.S. 36C-5-504(a)(2) broadly includes a discretionary trust interest to include discretionary distributions whether or not the discretion is expressed in the form of a standard of distribution. I-18